Financial Management

BAC 5006

Week 2 (lecture 2) and Week 3

Lecturers: Assoc.Prof. Do Hong Nhung (PhD)

 Financial Management

Measuring Achievement of
Corporate Objectives

Financial Ratio Analysis-2

 COMMENTS ON THE PERFORMANCE OF THE COMPANY

• BASED ON CALCULATIONS CARRIED OUT

• Firstly, state whether the ratio has increased/decreased or
improved/deteriorated from
➢ last year

➢ industry average

➢ another company.

• Explain reasons for the change

• profitability, liquidity, use of resources and Gearing.
 Your focus should be on any changes i.e. if Gross profit margin stays the same over
the past two years you do not need to restate this;
 only give comments on changes that have occurred and any reasons you anticipate
for these changes.

Sensitivity: Internal
 Ratio Increase/Improved Decrease/Deteriorated

Less profits generated from investment in

More profits generated from investment in the company than from other
Return on Shareholder’s
the company than from other means/investments e.g. an ISA. This can
Funds/ Equity
means/investments e.g. an ISA. affect the amount shareholders may want
to invest in the future

Less profit generated per £1 of capital

More profit generated per £1 of capital employed. Therefore capital employed is
employed. Therefore capital employed is not efficient.
Return on Capital Employed
efficient. Compare to other investments
e.g. ISA/other companies Compare to other investments e.g.
ISA/other companies

Generating more net profit from sales. Generating less net profit from sales. Due
Due to increased sales margins or to decreased sales margins or increase in
Operating
decrease in expenses. expenses.
(Net) Profit
Compare to gross profit to see where the Compare to gross profit to see where the
increase has occurred. decrease has occurred.

Increased sales margins or reduction in Decreased sales margins or increase in

Gross Profit cost of sales. cost of sales e.g new supplier, poor
Examples same as opposite buying, competition

Sensitivity: Internal
 Takes longer to sell stock or Co. is
holding too much inventory.
Depends on business but usually shows
Inventory Poor stock control
good stock control
turnover (days) Problems with overstocking
Getting rid of old stock quickly
Increased amounts of older stock,
perhaps obsolete

Should be less than payables days. Takes more days to collect money
Receivables owed. Receivables may have liquidity
Quicker in collecting money owed. Due to
collection problems and could lead to an increase
good internal debt control procedures i.e.
in bad debts.
(days) checking credit-worthiness before giving
credit Poor debt collection procedures

Paying debts slower, keeping money

Payables Paying debts too quickly – inefficiency of within the business. However, Co.
Payment management to make use of credit terms should ensure they are still within credit
(days) or pressure from suppliers arrangements. Also could indicate
problems with liquidity

Sensitivity: Internal
 Increasing sales from Decreasing sales from available
available resources, resources. Could have been affected
Asset Turnover/Sales
however too high may by decrease in sales and/or increase in
Revenue to Capital
suggest insufficient assets net assets. A recent purchase of a non-
Employed
to sustain the level of sales current asset would affect this ratio,
revenue achieved. although benefit the ratio next year
More current assets to meet
Working capital/
liabilities. Decreased liquidity
Current ratio
Better liquidity
Better liquidity however, Compare to Working capital, receivable
Acid Test/ should compare to working collection and payables days.
capital, receivable Decreased Liquidity therefore perhaps
Quick ratio collection and payables not able to meet liabilities as they fall
days due
Depends on the culture of Depends on culture of the industry
the industry.
High debt/gearing – risk of not being
able to pay interest charges from
Gearing profits. After these payments there is
Lenders like to see 50% or
a risk that dividends cannot be
less
afforded and therefore returns to
Sensitivity: Internal shareholders could be volatile
 The higher the better – looking for
Low ratio – company may get into
2:1.
difficulties if the interest rates
Company is likely to be able to increase. Affect whether
Interest Cover meet changing demands in interest Companies will lend you money
rates. Lenders will like to invest and shareholders unlikely to invest
and shareholders are likely to as less profits to pay in dividends.
receive dividends and will also
Could end up in liquidation
invest
More earnings attributable to each Less earnings attributable to each
EPS share than from other means, share than from other means,
e.g. an ISA e.g. an ISA
Low confidence in the company,
P/E ratio High confidence and expectations could be due to poor performance
for the company or even a high profile legal case
affecting perception of company
Dividend per
Increase in profits or change in Could be a drop in profits, or a
share and
company dividend policy result of a new share issue
Dividend Cover
Dividend yield Similar to above Similar to above

Sensitivity: Internal
 Comments on the performance
from different aspects
Performance Choices of ratio(s) Comments Overall
in
Profitability Profit margin(s), Concerned with Compare
ROCE effectiveness at to?
generating profit. Better or
Liquidity Current ratio, Acid Concerned with the worse?
ratio ability to meet short- Any
term debts. concern?
Any
Debt Gearing, debt Concerned with the solution?
controlling ratio, Interest relationship between
cover equity and debt
financing.
Efficiency Stock turnover, Concerned with
Receivable efficiency of using
(Payable) assets.
Sensitivity: Internal
collection days,
Financial Management

Financial Ratio Analysis

Example
Analysing & Interpreting
Financial Statements:
RATIO ANALYSIS
 Learners will be able to:
 Identify the categories of ratios;
 Calculate ratios for assessing financial
performance and position of a business;
 Explain the significance of the ratios
calculated;
 Discuss the limitations of ratios as a tool
of financial analysis.

Sensitivity: Internal
 FINANCIAL RATIO CLASSIFICATIONS

 Profitability - relationship between profit, revenue,

assets, equity and capital employed;

 Efficiency - how effectively and efficiently the assets

and liabilities are used;

 Liquidity - ability of business to stay solvent by

meeting its short-term financial obligations;

 Financial Gearing – relationship between debt and

equity financing, indication of risk;

 Investment – helping shareholders assess returns on

their investment.
Sensitivity: Internal
 Why use ratios?
 An aid to understanding what the accounts are saying.

 Inter year comparisons - to establish a trend from past

years, to provide a standard of comparison;

 Intra firm comparisons - to compare against a similar

business in the same industry;

 Benchmark - compare against industry averages.

An inexact science, so results must be interpreted cautiously.

One ratio may indicate something but other ratios and data
are needed to support and interpret it in order for a
meaningful evaluation.
Sensitivity: Internal
 Example 1: – BP’s Balance sheets at 3 (£000)
2019 2018

Non-current assets 1,800 1,400

Current assets
Inventory 1,200 200
Receivables 400 800
Cash 100 100
1,700 1,100
Total assets 3,500 2,500

Equity and liabilities

Ordinary share capital (@ £0.50) 1,200 500
Share premium 600 0
Reserves 200 100
2,000 600
Non-current liabilities
10% loan notes 1,000 600
Current liabilities
Trade payables 200 500
Other payables 300 800
500 1,300
Total equity and liabilities 3,500 2,500
Sensitivity: Internal
 BP’s Income Statements (£000) 2019 2018
Revenue 2,000 1,000
Cost of sales (1,300) (700)
Gross profit 700 300
Distribution costs (260) (90)
Administration expenses (100) (60)
Operating profit 340 150
Interest (100) (60)
Profit before taxation 240 90
Taxation (50) (20)
Profit after taxation 190 70
Ordinary dividends (90) (50)
Retained profit for the year 100 20
Profit and loss b/fwd 100 80
Profit and loss c/fwd 200 100

Sensitivity: Internal
 Share price (£) 1.30 1.26
Industry information:
Industry PE ratio 22 20
Industry average growth in EPS (%) 12 8

Sensitivity: Internal
 Profitability

Sensitivity: Internal
 Profitability

We will look at:

1. Return on Ordinary Shareholders’ Funds % (ROSF)/Return on Equity

2. Return on Capital Employed % (ROCE)

3. Operating profit margin (PBIT) %
4. Gross profit margin %

Sensitivity: Internal
 1. RETURN ON ORDINARY
SHAREHOLDERS’ FUNDS (EQUITY)

Profit after tax and preference dividends x 100%

ROSF/ =
ROE Ordinary share capital + reserves

 Measuring how much profit a company generates for its

ordinary shareholders with the money they have invested
in the company.

Example – BP:
2019 2018
ROSF = 190/2,000 70/600

9.5% 11.7%

Sensitivity: Internal
 2. RETURN ON CAPITAL EMPLOYED

ROCE = Operating profit (PBIT) x 100%

Capital employed*

* Usually where Capital Employed = Debt & Equity,

(i.e. Share Capital + Reserves + Non-current
liabilities)

 Measuring how efficiently a business is using the funds

available from all sources of long-term finance.
Example – BP:
2019 2018
ROCE = 340/3,000 150/1,200
11.33% 12.50%

Sensitivity: Internal
 3. OPERATING PROFIT MARGIN

Operating profit% = Operating profit (PBIT) x 100%

(PBIT) Sales Revenue
 Measuring the profit from trading operations (net
profit, before interest and tax) in relation to the sales
revenue for a period.

Example – BP:
2019 2018
Op Profit % = 340/2,000 150/1,000

17% 15%

Sensitivity: Internal
 4. GROSS PROFIT MARGIN

Gross profit % = Gross profit x 100%

Sales Revenue

 Measuring the gross profit (where GP = sales revenue

– cost of sales) in relation to the sales revenue for a
period.
Example – BP:
2019 2018
Gross Profit % = 700/2,000 300/1,000

35% 30%

Sensitivity: Internal
 Efficiency

Sensitivity: Internal
 Efficiency

We will look at:

5. Inventory turnover period (days)
6. Receivables collection period (days)
7. Payables payment period (days)
8. Sales Revenue to Capital
Employed/Asset Turnover (times)
Sensitivity: Internal
 5. INVENTORY TURNOVER PERIOD

Inventory = Closing inventories* held x 365

turnover period Cost of Sales

 The number of days inventory is held for. A longer

inventory turnover period indicates either a
slowdown in trading, or possible excessive
investment in inventory.
* Can also use average inventory [(opening + closing)/2]
Example – BP:
2019 2018

Inventory turnover= 1,200/1,300 x 365 200/700 x365

337 days 105 days
Sensitivity: Internal
 6. RECEIVABLES COLLECTION PERIOD

Receivables = Trade Receivables* x 365

settlement period Credit Sales Revenue
* Can also use average receivables [(opening + closing)/2]
 Average time taken for debtors to pay us. Useful to compare against a benchmark.
Average in UK is 30 days, but if international trade, it will take longer. Ideally this
should be shorter than trade payables days, and the lower the period, the better.

Example – BP:

2019 2018

Receivables period= 400/2,000 x 365 800/1,000 x 365

73 days 292 days

Sensitivity: Internal
 7. PAYABLES PAYMENT PERIOD

Payables = Trade Payables* x 365

settlement period Credit Purchases*
* Can also use average payables [(opening + closing)/2]

*can use COS as an approx. to purchases

 Average time taken for business to pay suppliers. Useful
to compare against a benchmark. Ideally this should be
longer than trade receivables days, although delaying too
much can cause problems e.g. loss of goodwill.
Example – BP:
2019 2018

Payables period= 200/1,300 x 365 500/700 x 365

57 days 271 days

Sensitivity: Internal
8. SALES REVENUE TO CAPITAL EMPLOYED

SR:CE ratio = Sales Revenue

Capital Employed*
*Where Cap. Employed = Share Capital + Reserves +
Non-current liabilities
 Also known as Asset Turnover. Measures efficiency of the use of Net Assets in generating Sales;
year on year comparison used.
 A fall in ratio could be due to reduction in Sales or increase in Net Assets.
 Depends on company – engineering company will be low, supermarket with few assets will be high.

Example – BP:

2019 2018

Asset turnover = 2,000/3,000 1,000/1,200

0.67 times 0.83 times

Sensitivity: Internal
 Liquidity

Sensitivity: Internal
 Liquidity

We will look at:

9. Current Ratio – the standard liquidity
test
10. Acid Test Ratio (also known as quick
ratio)

Sensitivity: Internal
 9. CURRENT RATIO

Current ratio = Current Assets :1

Current Liabilities

 Indicates how comfortable a company’s

current assets can meet its commitments to
pay its current liabilities. Should be
comfortably in excess of 1:1.
Example – BP:
2019 2018

Current ratio= 1,700/500 1,100/1,300

3.4:1 0.85:1
Sensitivity: Internal
 10. ACID TEST RATIO

Acid Test ratio = Current Assets - Inventories : 1

Current Liabilities

Useful for companies with slow inventory turnover

(and so long cash cycles). Should ideally be at least
1:1, can be lower if fast inventory turnover but
below this indicates a business may not be able to
meet its current liabilities.
Example – BP:
2019 2018

Acid test ratio= 500/500 900/1,300

1:1 0.69:1
Sensitivity: Internal
 Financial Gearing

Sensitivity: Internal
 Financial Gearing

We will look at:

11. Capital Gearing ratio
12. Debt: Equity Ratio
13. Interest Cover ratio

Sensitivity: Internal
 11. FINANCIAL GEARING

Capital Gearing = Long-term (non-current) liabilities x100

Share capital + Reserves + Long-term (non-current) liabilities

 Long-term capital structure, mix of debt & equity.

 Higher the gearing, the less secure will be the
financing of the company and therefore its future
(usually)

Example – BP:
2019 2016

Gearing ratio= 1,000/3,000 600/1,200

33.3% 50%
Sensitivity: Internal
 12. DEBT: EQUITY RATIO

Debt: Equity= Long-term (non-current) liabilities x100

Share capital + Reserves (Equity)
 Long-term capital structure, mix of debt & equity.

 Higher the gearing, the less secure will be the

financing of the company and therefore its future
(usually)

Example – BP:
2019 2018

Gearing ratio= 1,000/2,000 600/600

Sensitivity: Internal 50% 100%
 13. INTEREST COVER RATIO

 Interest Cover = Operating profit (PBIT)

Interest payable

 Measures amount of operating profit available to

cover interest payable.
 The higher the better, as low coverage means risk to
lenders that interest payments will not be met.

Example – BP:
2019 2018

Interest cover= 340/100 150/60

3.4 times 2.5 times
Sensitivity: Internal
 Shareholders’ Investment Ratios

Sensitivity: Internal
 Shareholders’ Investment Ratios

We will look at:

14. Earnings per share
15. P/E ratio
16. Dividend per share
17. Dividend Cover
18. Dividend yield

Sensitivity: Internal
 14. EARNINGS PER SHARE

EPS = Profit distributable to ordinary shareholders (PAT)

Number of shares in issue

 Measuring a company’s performance from an

ordinary shareholder’s point of view.
 Usually expressed in pence
 Comparison on previous years is used.

Example – BP:
2019 2018
EPS = 190/2,400 70/1,000
7.92p 7p

The growth rate of EPS = (7.92 -7)/7 x 100% = 13%

Sensitivity: Internal
 15. PRICE EARNINGS RATIO

P/E ratio = Share Price

EPS
 The amount the shareholders are prepared to
pay for the share as a multiple of current
earnings.
 High = strong shareholder confidence.
 Can be compared against all other companies.

Example – BP:
2019 2018
PE ratio = 130/7.92 126/7
16.4 times 18 times

Sensitivity: Internal
 16. DIVIDEND PER SHARE

DPS = Total ordinary dividend

Total no. of shares issued

 How much of the overall dividend

payout the shareholders are entitled
to.
Example – BP:
2019 2018
DPS = 90/2,400 50/1,000
3.75p 5p
Sensitivity: Internal
 17. DIVIDEND COVER

DIVIDEND COVER = Profits after tax or:

Earnings per share
Dividends Dividend per share

 Measures how many times the earnings

available for dividend cover the actual
dividend.
 Inverse =dividend payout ratio.

Example – BP:
2019 2018
Dividend cover = 7.92/3.75 7/5
2.1 times 1.4 times
Sensitivity: Internal
 18. DIVIDEND YIELD

Dividend yield = DPS x 100

Market price per share

 Measuring the wealth in terms of a return

received by the ordinary shareholders.
Example – BP:
2019 2018
Dividend yield = 3.75/130 5/126
2.9% 4%

Sensitivity: Internal
Example – BP
Performance in Ratios 2019 2018
Profitability ROCE 11.33% 12.50%
OPM 17% 15%
GPM 35% 30%
Liquidity CR 3.4:1 0.85:1
AR 1:1 0.69:1
Debt controlling D/E 50% 100%
Interest Cover 3.4 times 2.5 times
Efficiency STO 337 days 105 days
RCP 73 days 292 days
PPP 57 days 271 days
COC 353 days 126 days
Investment EPS 7.92p 7p
P/E 16.4 18
DPS 3.75p 5p
Dividend Cover 2.1 1.4
Sensitivity: Internal Dividend yield 2.9% 4%
 Question of the week

What are the limitations of

using accounting ratios as
measurement of companies’
performance?

Sensitivity: Internal
Example 2
Balance Sheets
Fama Plc Brass Plc
31.12.2019 31.12.2019
£ £ £ £
Fixed Assets 600,000 800,000
Current Assets:
Stock 100,000 200,000
Debtors 80,000 160,000
Cash 20,000 240,000
200,000 600,000
Current Liabilities:
(includes proposed dividends) (176,000) 24,000 (306,000) 294,000
624,000 1,094,000
Capital and Reserves
Ordinary £1 shares 560,000 600,000
Preference £1 shares (6%) 100,000
Reserves – P&L a/c 4000 194,000
8% Debentures 60,000 200,000
624,000 1,094,000
Market Share Price £1.50 £2.00

Sensitivity: Internal
 Income Statements
Fama Plc Brass Plc

Sales 1,040,000 1,386,000

Cost of Sales 728,000 386,000
Gross Profit 312,000 1,000,000
Expenses
(includes debenture interest) 236,800 884,000
Net Profit Before tax 75,200 116,000
Tax 17,200 24,000
Profit Before Dividends 58,000 92,000
Dividends
- Ordinary 28,000 44,000
- Preference 6,000
Retained Profit 30,000 42,000

Sensitivity: Internal
 Required:
Compare and contrasting the financial performance of Fama Plc and Brass
Plc using following ratios:
a) ROCE, GPM, OPM, NPM;
b) Gearing, Interest cover;
c) Current ratio, Acid ratio (Quick ratio);
d) ROE, EPS, DPS, P/E, Dividend yield.
Based on the results, identifying any issues that you consider should be
brought to the attention for your managing director.

Sensitivity: Internal
 Profitability Fama Brass Investment Fama Brass

ROCE 12.82% 12.07% ROE 10.28% 10.83%

GPM 30% 72.15% EPS £0.10 £0.14
OPM 7.69% 9.52% DPS £0.05 £0.07
NPM 5.58% 8.27% P/E 15 14.29
DY 3.33% 3.67%

Debt Fama Brass Liquidity Fama Brass

Gearing 10.64% 37.79% Current ratio 1.14:1 1.96:1

Interest cover 16.67 6 Acid ratio
0.57:1 1.31:1

Sensitivity: Internal
 Encouraging the achievement of stakeholder
objectives

• It is argued that management will only make optimal

decision if they are monitored and appropriate incentives are
given.
• Remuneration incentives are:
- Performance related pay.
- Rewarding managers with shares.
- Executives share options plans (ESOPs).

Slide
51

Sensitivity: Internal
 Encouraging the achievement of stakeholder objectives

Regulatory requirements: Shareholder

objectives can be enforced using

Corporate governance
Stock Exchange listing
(code of best practice)
rules and regulations
The system by which
Rules & regulation to
organizations are directed and
ensure that the stock market
controlled such as:
operates both efficiently and fairly
•Risk reduction.
For all parties
•Enhance performance.
(Issuers, investors and brokers).
•Code of ethics.
.
•Accountability.

Slide
52

Sensitivity: Internal
 Summary

• Have a good read of financial statements.

• Choose the correct ratios.
• Analysis has to be backed by the results.
• Address the significant issues, providing possible causes/solutions.

Sensitivity: Internal
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